There is a case for banks withholding rate cut

David Murray

This week's decision by the Reserve Bank to cut the cash rate to 3 per cent raises the question: why should rates fall when the economy is still growing close to its long-term trend rate?

Two important factors at play are the "safe haven" buying of Australian government bonds by foreign investors (including central banks) causing the dollar to stay strong, and the prospect of a sharp fall in mining-related investment, with a project completion lag.

A strong dollar and its "two-speed" effect means most Australians are not feeling the mining investment boom. Their relatively high level of mortgage indebtedness and propensity to save more since the global financial crisis results in a prurient political interest in lower interest rates. This political interest should be viewed against the reality that both the Treasurer, Wayne Swan, and the Treasury have the facts and analysis to grasp the consequences of lower rates, including whether the banks should “pass them on” to their mortgagor in full.

They both know the Reserve Bank deliberates with respect to the economic outlook and the "transmission effect" in the banking system – whether the banks through their credit policies, cost of funds, and regulatory requirements for capital and liquidity are likely to adjust rates by more or less than changes in the monetary policy setting. They know in detail the continuing consequences of the global financial crisis and the funding pressures, real and contingent, on the Australian economy and its banks.

In general terms, we need the banks to be able to grow their lending in line with the growth in the economy – usually a little more so as to allow for business fixed asset replenishment to drive continuous productivity improvement.

Advertisement

To achieve this, the banks need to retain sufficient equity returns to match credit growth through the economic cycle. If their margins contract in periods of low credit growth, they will only have to raise them again as growth picks up – thereby slowing the growth potential. Further, we need them to pay a sufficient dividend to keep a competitive cost of capital and be very efficient generally.

Since the crisis, the banks' ability to fund credit has been reduced by regulatory requirements for more capital, the holding of more non-lending assets in the form of liquid securities including government bonds and the upcoming changes in corporate tax collection. The continuing global difficulties, particularly in Europe, mean banks are paying historically high rates for term deposits. Accordingly, they have narrowed their margin on deposits and widened it on loans, but not changed it overall. To have reduced the overall margin would have caused an even larger contraction in their return on equity.

Banks need a return of about 16 per cent to do their job, and they need to ensure it supports an adequate credit rating so they are not exposed to any further offshore funding disruption. Similarly, in the difficult global conditions of today, the federal government needs to keep its AAA rating. Failure to do so means banks and state governments may not be able to retain their ratings. This is why the federal government needs to get to a budget surplus, not a pretend accounting adjusted surplus, but one that caps its still rising debt.

It is understandable that banks are not fully reflecting the 25-basis-point fall in the cash rate this week.

Still, borrowers will welcome a further reduction in home mortgage rates although many do not change their repayments. But we should be careful what we hope for. If this results in higher house prices, we will be going back to where we started. If, as many economists understand, easier monetary policy at low rates is less likely to spur growth, and the dollar remains high, then jobs will remain vulnerable in the two-speed economy – and households will remain vulnerable.

In all this frenzy for lower rates, the consequences for savers do not get a good airing. Near zero monetary settings in Europe and the US are having the effect globally, of reducing returns to savers and lowering the cost of borrowing to governments. With falling yields on term deposits and already weak returns over five years on their superannuation funds, savers will redirect their investments and/or start to limit their consumption.

Just as governments in Europe and the US should have begun some structural reform and fiscal consolidation, the Australian government must do the same to get the economy moving more broadly. This means a serious start on productivity improvement to attack high domestic costs. Allowing the debate to descend to bank jawboning or a Melbourne Cup-style national fascination with the monthly Reserve Bank meeting will result in us all missing out.